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Tutorial 2 Elasticity

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Elasticity 1 The price of orange falls from 15B to 10B per kilogram and the quantity demanded goes from 100,000 to 200,000 kilograms. Use the midpoint method to find the price elasticity of demand.

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**Solution 1 % change in price 15 B – 10 B 5 (15 B + 10 B)/2 12.5**

% change in quantity 200,000 – 100, ,000 (200, ,000)/ ,000 X 100 = 67% X 100 = X 100 = 40% Therefore the price elasticity of demand using the midpoint method = 67% / 40% = 1.7

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Elasticity 2 At the present level of consumption, 4,000 movie tickets, and at the current price, 120B per ticket, the price elasticity of demand for movie tickets is 1. Using the midpoint method, calculate the percentage by which the owners of movie theaters must reduce price in order to sell 5,000 tickets.

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Solution 2 Since the price elasticity of demand = 1 at the current consumption level, it will take a 22% drop in the price of movie tickets to generate a 22% increase in quantity demanded By the midpoint method, the % change in the quantity of movie tickets demanded in going from 4,000 to 5,000 tickets is % change in quantity 4,000 – 5, ,000 (4, ,000)/ ,500 X 100 = 22% X 100 =

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Elasticity 3 The price elasticity of demand for ice-cream cone is 1.2 at the current price of 50B per cone and the current consumption level of 100,000 cones. Calculate the change in quantity demanded when price rises by 5B. Calculate % change in price and % change in quantity demanded.

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Solution 3 Since price rises, we know that quantity demanded must fall. Given the current price of 50B, a 5B increase in price represents a 10% change % change in quantity demanded = Price elasticity = % change in quantity demanded % change in price = % change in quantity demanded 10% 12% = % change in quantity demanded

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Elasticity 4 For each case, choose the condition that characterizes demand: elastic demand, inelastic demand, or unit-elastic. a. Total revenue decreases when price increase.

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Solution 4 Elastic Demand. Consumers are highly responsive to changes in price. For a rise in price, the quantity effect (which tends to reduce total revenue) outweighs the price effect (which tends to increase total revenue). Overall, this leads to a fall in total revenue.

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Elasticity 4 The additional revenue generated by an increase in quantity sold is exactly offset by revenue lost from the fall in price received per unit. Total revenue falls when output increases.

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Solution 4 Unit-elastic demand. Here the revenue lost to the fall in price is exactly equal to the revenue gained from higher sales. The quantity effect exactly offsets the price effect. Inelastic demand. Consumer are relatively unresponsive to changes in price. For consumers to purchase a given percent increase in output, the price must fall by an even greater percent. Price effect > Quantity effect = revenue increases

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Elasticity 5 For the following goods, what is the elasticity of demand? Explain. What is the shape of the demand curve? a. Demand by a snake-bite victim for an antidote b. Demand by students for green erasers

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Solution 5 Once bitten by a venomous snake, the victim’s demand for an antidote is very likely to be perfectly inelastic because there is no substitute and it is necessary for survival. The demand curve will be vertical, at a quantity equal to the needed dose.

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Solution 5 Students’ demand for green erasers is likely to be perfectly elastic because there are easily available substitutes: Non-green erasers. The demand curve will be horizontal, at a price equal to that of non-green erasers.

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Externalities What type of externality is described in each of the following examples? Is the marginal social benefit greater than or equal to the private marginal benefit? Is the marginal social cost greater than or equal to the private marginal cost? Without intervention, will there be too little or too much of this activity?

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Externalities Dr. Alice plants lots of colorful flowers in her front yard Nike, a popular clothing store, opens in a mall, attracting more shoppers who also visit other stores. The karaoke shop next to your dorm plays loud music, keeping you from studying. Dr. Wanwipa buys a large car that consumes a lot of gasoline.

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Solution a. This is a positive externality: since other people enjoy looking at Dr. Alice’s flowers, the marginal social benefit of looking at the flowers is greater than the marginal benefit to Dr. Alice of looking at them. As a result, fewer flowers will be planted than is socially optimal. b. This is a positive externality: since additional shoppers lead to additional business for other stores in the mall, the store’s decision to locate there confers external benefits on other stores. The marginal social benefit is greater than the marginal benefit to NIKE alone. Since NIKE do not take the external benefit into account in their decision making, they will open fewer stores in malls than is socially optimal.

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Solution c. This is a negative externality: since you cannot study, an external cost is imposed on you. That is, the marginal social cost is greater than the marginal cost incurred by the karaoke shop. Since the karaoke shop does not take this external cost into account, there will be more music played (or the music will be louder) than is socially optimal. e. This is a negative externality: the burning of gasoline produces toxic gases that impose an external cost on others. The marginal social cost is greater than the marginal cost incurred by Dr. Wanwipa. As a result, more people will purchase cars than is socially optimal.

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Externalities Getting a flu shot reduces not only your chance of getting the flu but also the chance that you will pass it onto someone else. A. Draw a diagram showing the supply and demand curves of inoculating different proportions of the population. Assume that the marginal cost of each flu shot is constant and is equal to the marginal social cost, and that the demand curve is downward sloping.

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Externalities B. Will the marginal social benefit curve be higher, lower or the same as the demand curve? Why? Draw the marginal social benefit curve into your diagram. C. In your diagram show the market equilibrium quantity and the socially optimal quantity of flu shots. Is the market equilibrium quantity of flu shots socially efficient? Why or why not?

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Solution

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Solution b. The marginal social benefit will be higher than the marginal benefit of the person inoculated because there is an external benefit: others who come into contact with this person now cannot get the flu from him or her. The curve labeled MSB illustrates this. c. The market equilibrium quantity of flu shots is quantity QMKT at point A, where supply and demand are equal. The socially optimal quantity of flu shots is quantity QOPT at point B, where supply and marginal social benefit are equal. The market-determined quantity is not efficient: at that quantity, the marginalsocial benefit is greater than the marginal cost (represented by the supply curve). That is, immunizing one more person would bring greater benefit to society, including the immunized person and those in contact with her, than it would cost to provide the immunization.

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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Describing Supply and Demand: Elasticities Chapter 6.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Describing Supply and Demand: Elasticities Chapter 6.

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